Hedge fund returns won’t save public pensions

State pension funds are putting more of their money into higher risk investments like hedge funds, private equity, real estate, and commodities. But it won’t fix their problems.

As most everyone knows (and as politicians and public workers in Wisconsin, New Jersey, and New York are acutely aware) state and local pension funds could use some big investment paydays. The funds have pension and retiree healthcare obligations that they can’t afford to pay.

Pension fund managers have been pushing to allocate more to alternatives since 2005, hoping that the new strategy would generate higher returns. Academics and public worker unions voiced concern, but hedge funds and private equity seemed too lucrative to ignore as markets rose through 2007.

With markets rising again, the number of public pension funds that have allocated money to hedge funds has increased by 51% since 2007, according to a study by Preqin; the mean allocation to hedge funds, meanwhile, nearly doubled over the same period to 6.6%.

The San Diego County Employees’ Retirement Association (SDCERA) may increase allocations to approved alternative asset managers, without getting additional authorization, reports HFMWeek. It follows a similar move made last year by the Arizona Public Safety Personnel Retirement System (PSPRS).

The New Jersey State Investment Council is also jumping in — it recently voted 8-3 to invest up to 38% of the state’s pension funds in an array of alternative investments, up from its current allocation of about 15%. The change could be approved in May.

But these investment moves don’t solve the real problem facing the pension system, says Douglas Forrester, who served as director of pensions in New Jersey in the 1980s. “The current problem is not a result of lower than average investment returns, so higher than average returns won’t really make things better,” he says.

The current pension fiasco stems from several things, says Donald Boyd, a senior fellow at the Nelson A. Rockefeller Institute of Government. Pensions have been willfully underfunded by local governments, and investment committees have used a mish-mash of accounting tricks to make pension funds seem healthier than they actually are. Moreover, investment losses incurred in 2008 and beyond greatly exacerbate the problem.

New Jersey perfectly exemplifies this bad brew. In a story two years ago called The Public Pension Bomb, Fortune examined how the state — one of the wealthiest in the country — underfunded its public pension and used high finance to minimize the problem on paper.

In New Jersey (as in most cases), these moves were political. In a nutshell, a string of governors diverted money from the public pension pot and used accounting chicanery to hide the deficit. They could then lower taxes and increase public worker benefits — moves politicians have long depended upon to get themselves reelected.

So while hedge fund investments may goose returns, the new investment allocations are not a quick fix.

Rather, it is imperative to take care of the political roots of the pension problem, says Forrester. For some politicians in Wisconsin and New Jersey, that means tearing up worker contracts, raising the retirement age, or increasing worker contributions to benefit plans. These moves could just be a start — while they would certainly lower the bill, the political motivations and machinations that made the mess would still be in place.

Forrester believes that at its heart, the pension problem is a governance issue. “Politicians right now may be fighting to get money into pension funds, but administrations will come and go,” he says. He argues that if pension funds are still controlled or influenced by politicians, it’s only a matter of time before a new wave of elected officials decides to underfund them again.

A real solution would be to remove the pension decision-making process from the political structure. Forrester likens changes to investment allocations, and disputes over worker benefits, to fighting off alligators when you’re trying to reclaim a swamp. “You’re facing down alligators and coming up with ways to fight them, but you still need to remember the bigger picture is to drain the swamp.”